What is pension compound interest and why is it so powerful?

Contributing to your pension pot early means you can make the most out of the various financial advantages that may come from saving over many years. Compound interest is one such benefit.

Compound interest is a powerful and important concept that many people utilise to ensure their wealth grows exponentially as their investments build interest over time.

What exactly does it consist of, and how can you start capitalising on it as soon as possible? Read on to find out more.

How Does Compound Interest Work?

Compound interest is essentially interest on your interest. This happens when your interest is reinvested, which in turn, accumulates over time.

This means that even smaller pension pots can grow substantially, provided they are left untouched, and the accumulating interest has a chance to benefit from reinvestment. If you are wondering, “what is the best way to invest my pension?” taking advantage of compound investing is the right way to go.

Let’s take a simple scenario as an illustration of how this might work in practice. Say you made an initial contribution of £1000 into a savings account with a return of 5% per year. After the first year, your savings would stand at £1050. Compound interest gets to work after the next year that your savings are invested, growing to £52.50 a year (if the interest rate stays at 5%). This is the result of 5% interest on your existing interest.

The longer you leave your savings to accumulate interest, the better your yearly return will be. Using the previous example, after 20 years, your savings would be making £155.14 per year, resulting in a fund of around £3256, all from your initial investment.

When combined with regular contributions, like a workplace pension scheme for example, you can start to see how compound interest can make a sizeable impact to your final pot.

Saving into Your Pension Early

For those of you who wish to leave your savings to grow for as long as possible without drawing from the pot at the first available opportunity, compound interest can be an immense advantage.

Compound interest truly shines when it gets a chance to grow for as long as possible, which is one of the reasons why investing in a pension plan early is so important.

Even if you are only able to invest a little bit of money each month, the effects of compound interest on your pension can help you maximise what you do put in.

Taking a look at a few time-sensitive examples might help you visualise these effects. Say you started investing £1000 per year when you were 18 and stopped when you reached 28; having invested for 10 years, you would have saved £10,000.

Your £10,000 will then continue to grow through compound interest, snowballing into a much larger amount over time. In comparison, (and provided the rate of return remains the same) someone who starts saving £1000 per year at age 28, and continues to invest until they retire at 55, will have invested more money, but their compound interest will have had less time to accumulate.

This means that despite having saved for longer and having contributed more money overall, there is a chance they would have less money in their final retirement fund than someone who started investing less money earlier on in their life, even if they stopped contributing after ten years.

Tax Relief

Compounding is powerful indeed, but when it’s combined with the tax relief scheme offered by the government, pension contributions become an extremely effective method for maximising your savings.

You can get a tax relief of up to 20% on your pension contributions, which means that you essentially get a tax bonus when you make payments. For example, if you paid in £100, the government would refund you £20 pounds of tax, resulting in a final contribution figure of £120.

Put compound interest on top of this, and even small contributions start to add up quickly.

Conclusion

Saving into a pension as early as you can is a great way to prepare for retirement and could mean smaller investments grow much larger over time.

It is important to note that all examples above are for illustration purposes only. Pensions are investment products which means they are subject to fluctuations in the market and the value of your pension fund can go down as well as up. However, over time it is easy to see that if your investments perform well, the added effects of compound investing could help your pot to grow.

If you have several pension pots scattered around, it could be beneficial to you to have all your savings in one easy to manage scheme. iSIPP can help you consolidate your pensions and enable you to gain greater control over your investments in the future. Why not contact our friendly team here for more information and insights into how we could help you make the most of your pension.

Disclaimer 

The content of this article is for general information purposes only and should not be construed as legal, financial or taxation advice. You should not rely on the information contained in this article as legal, financial or taxation advice. The content of this article is based on information currently available to us, and the current laws in force in the UK. The content does not take account of individual circumstances and may not reflect recent changes in the law since the date it was created. It is essential that detailed financial and tax advice should be sought in both jurisdictions and any legal advice, if required.

This notice cannot disclose all the risks associated with the products we make available to you. When making your own investment decisions it is important you understand that all investments can fall as well as rise in value and it is possible you may get back less than what you have paid in. You should also be satisfied that any investments you choose are suitable for you in the light of your circumstances and financial position. You should seek financial advice if you are not sure of what’s best for your situation.